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The Cost of Capital Approach Suggests That Disney Should Do the Following… The cost of capital approach suggests that Disney should do the following… ¨ Disney currently has $15.96 billion in debt. The optimal dollar debt (at 40%) is roughly $55.1 billion. Disney has excess debt capacity of 39.14 billion. ¨ To move to its optimal and gain the increase in value, Disney should borrow $ 39.14 billion and buy back stock. ¨ Given the magnitude of this decision, you should expect to answer three questions: ¤ Why should we do it? ¤ What if something goes wrong? ¤ What if we don’t want (or cannot ) buy back stock and want to make investments with the additional debt capacity? Aswath Damodaran 55 Why should we do it? Effect on Firm Value – Full Valuation Step 1: Estimate the cash flows to Disney as a firm EBIT (1 – Tax Rate) = 10,032 (1 – 0.361) = $6,410 + Depreciation and amortization = $2,485 – Capital expenditures = $5,239 – Change in noncash working capital $0 Free cash flow to the firm = $3,657 ¨Step 2: Back out the implied growth rate in the current market value Current enterprise value = $121,878 + 15,961 - 3,931 = 133,908 Value of firm = $ 133,908 = FCFF (1+g) 3, 657(1+g) 0 = (Cost of Capital -g) (.0781 -g) Growth rate = (Firm Value * Cost of Capital – CF to Firm)/(Firm Value + CF to Firm) = (133,908* 0.0781 – 3,657)/(133,908+ 3,657) = 0.0494 or 4.94% ¨Step 3: Revalue the firm with the new cost of capital FCFF (1+g) 3, 657(1.0494) ¤Firm value = 0 = = $172, 935 million (Cost of Capital -g) (.0716 -0.0484) ¤Increase in firm value = $172,935 - $133,908 = $39,027 million Aswath Damodaran 56 Effect on Value: Incremental approach ¨ In this approach, we start with the current market value and isolate the effect of changing the capital structure on the cash flow and the resulting value. Enterprise Value before the change = $133,908 million Cost of financing Disney at existing debt ratio = $ 133,908 * 0.0781 = $10,458 million Cost of financing Disney at optimal debt ratio = $ 133,908 * 0.0716 = $ 9,592 million Annual savings in cost of financing = $10,458 million – $9,592 million = $866 million Annual Savings next year $866 Increase in Value= = = $19, 623 million (Cost of Capital - g) (0.0716 - 0.0275) Enterprise value after recapitalization = Existing enterprise value + PV of Savings = $133,908 + $19,623 = $153,531 million Aswath Damodaran 57 From firm value to value per share: The Rational Investor Solution ¨ Because the increase in value accrues entirely to stockholders, we can estimate the increase in value per share by dividing by the total number of shares outstanding (1,800 million). ¤ Increase in Value per Share = $19,623/1800 = $ 10.90 ¤ New Stock Price = $67.71 + $10.90= $78.61 ¨ Implicit in this computation is the assumption that the increase in firm value will be spread evenly across both the stockholders who sell their stock back to the firm and those who do not and that is why we term this the “rational” solution, since it leaves investors indifferent between selling back their shares and holding on to them. Aswath Damodaran 58 The more general solution, given a buyback price ¨ Start with the buyback price and compute the number of shares outstanding after the buyback: ¤ Increase in Debt = Debt at optimal – Current Debt ¤ # Shares after buyback = # Shares before – Increase in Debt Share Price ¨ Then compute the equity value after the recapitalization, starting with the enterprise value at the optimal, adding back cash and subtracting out the debt at the optimal: ¤ Equity value after buyback = Optimal Enterprise value + Cash – Debt ¨ Divide the equity value after the buyback by the post- buyback number of shares. ¤ Value per share after buyback = Equity value after buyback/ Number of shares after buyback Aswath Damodaran 59 Let’s try a price: What if can buy shares back at the old price ($67.71)? ¨ Start with the buyback price and compute the number of shares outstanding after the buyback ¤ Debt issued = $ 55,136 - $15,961 = $39,175 million ¤ # Shares after buyback = 1800 - $39,175/$67.71 = 1221.43 m ¨ Then compute the equity value after the recapitalization, starting with the enterprise value at the optimal, adding back cash and subtracting out the debt at the optimal: ¤ Optimal Enterprise Value = $153,531 ¤ Equity value after buyback = $153,531 + $3,931– $55,136 = $102,326 ¨ Divide the equity value after the buyback by the post- buyback number of shares. ¤ Value per share after buyback = $102,326/1221.43 = $83.78 Aswath Damodaran 60 Back to the rational price ($78.61): Here is the proof ¨ Start with the buyback price and compute the number of shares outstanding after the buyback ¤ # Shares after buyback = 1800 - $39,175/$78.61 = 1301.65 m ¨ Then compute the equity value after the recapitalization, starting with the enterprise value at the optimal, adding back cash and subtracting out the debt at the optimal: ¤ Optimal Enterprise Value = $153,531 ¤ Equity value after buyback = $153,531 + $3,931– $55,136 = $102,326 ¨ Divide the equity value after the buyback by the post- buyback number of shares. ¤ Value per share after buyback = $102,326/1301.65 = $78.61 Aswath Damodaran 61 2. What if something goes wrong? The Downside Risk 62 ¨ Sensitivity to Assumptions A. “What if” analysis The optimal debt ratio is a function of our inputs on operating income, tax rates and macro variables. We could focus on one or two key variables – operating income is an obvious choice – and look at history for guidance on volatility in that number and ask what if questions. B. “Economic Scenario” Approach We can develop possible scenarios, based upon macro variables, and examine the optimal debt ratio under each one. For instance, we could look at the optimal debt ratio for a cyclical firm under a boom economy, a regular economy and an economy in recession. ¨ Constraint on Bond Ratings/ Book Debt Ratios Alternatively, we can put constraints on the optimal debt ratio to reduce exposure to downside risk. Thus, we could require the firm to have a minimum rating, at the optimal debt ratio or to have a book debt ratio that is less than a “specified” value. Aswath Damodaran 62 Disney’s Operating Income: History Recession Decline in Operating Income Standard deviation in % 2009 Drop of 23.06% change in EBIT = 19.17% 2002 Drop of 15.82% 1991 Drop of 22.00% 1981-82 Increased by 12% Aswath Damodaran Worst Year Drop of 29.47% 63 Disney: Safety Buffers? Aswath Damodaran 64 Constraints on Ratings ¨ Management often specifies a 'desired rating' below which they do not want to fall. ¨ The rating constraint is driven by three factors ¤ it is one way of protecting against downside risk in operating income (so do not do both) ¤ a drop in ratings might affect operating income ¤ there is an ego factor associated with high ratings ¨ Caveat: Every rating constraint has a cost. ¤ The cost of a rating constraint is the difference between the unconstrained value and the value of the firm with the constraint. ¤ Managers need to be made aware of the costs of the constraints they impose. Aswath Damodaran 65 Ratings Constraints for Disney ¨ At its optimal debt ratio of 40%, Disney has an estimated rating of A. ¨ If managers insisted on a AA rating, the optimal debt ratio for Disney is then 30% and the cost of the ratings constraint is fairly small: Cost of AA Rating Constraint = Value at 40% Debt – Value at 30% Debt = $153,531 m – $147,835 m = $ 5,696 million ¨ If managers insisted on a AAA rating, the optimal debt ratio would drop to 20% and the cost of the ratings constraint would rise: Cost of AAA rating constraint = Value at 40% Debt – Value at 20% Debt = $153,531 m – $141,406 m = $ 12,125 million Aswath Damodaran 66 3. What if you do not buy back stock.. 67 ¨ The optimal debt ratio is ultimately a function of the underlying riskiness of the business in which you operate and your tax rate. ¨ Will the optimal be different if you invested in projects instead of buying back stock? ¤ No. As long as the projects financed are in the same business mix that the company has always been in and your tax rate does not change significantly. ¤ Yes, if the projects are in entirely different types of businesses or if the tax rate is significantly different. Aswath Damodaran 67 Extension to a family group company: Tata Motor’s Optimal Capital Structure Tata Motors looks like it is over levered (29% actual versus 20% optimal), perhaps because it is drawing on the debt capacity of other companies in the Tata Group. Aswath Damodaran 68 Extension to a firm with volatile earnings: Vale’s Optimal Debt Ratio Replacing Vale’s current operating income with the average over the last three years pushes up the optimal to 50%. Aswath Damodaran 69 Optimal Debt Ratio for a young, growth firm: Baidu The optimal debt ratio for Baidu is between 0 and 10%, close to its current debt ratio of 5.23%, and much lower than the optimal debt ratios computed for Disney, Vale and Tata Motors. Aswath Damodaran 70 Extension to a private business Optimal Debt Ratio for Bookscape Debt value of leases = $12,136 million (only debt) Estimated market value of equity = Net Income * Average PE for Publicly Traded Book Retailers = 1.575 * 20 = $31.5 million Debt ratio = 12,136/(12,136+31,500) = 27.81% The firm value is maximized (and the cost of capital is minimized) at a debt ratio of 30%.
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